Accelerating climate action

We all know we are running out of time to address climate change. Based on existing climate policies and forecasts of future emissions by the Intergovernmental Panel on Climate Change, we have just a 5% chance of keeping global temperature rises below 2°C – levels at which the consequences remain manageable. It is now considered more likely than not that warming will exceed 3°C, leading to a big uptick in extreme weather events.

Our economic system, which is driving these trends, is clearly unsustainable. With outstanding equities and bonds standing at $160 trillion, the financial services industry oversees the global economy. If we manage to avoid the worst effects of global warming, we will need financiers to help fund the transition to the low-carbon economy.

Climate change is bad for business. According to the Economist Intelligence Unit, the expected losses to investment portfolios due to climate change in today’s money lie between $4.2 trillion and $13.9 trillion. Losses in a 4-6°C warmer world would be much greater. These estimates are conservative and disregard social and political costs.

Funding the green transition should not be seen as a cost or a burden to investors who take a long-term view. But since many investors are assessed by short-term performance, they have an incentive to follow shorter-term strategies. Long-term risks and rewards often take a back seat. And for those who can consider longer-term risks, there are not enough green investment opportunities into which they can redirect their capital.

We face what Bank of England Governor Mark Carney calls the ‘tragedy of the horizon’. The risks of climate change arise in the future, but we need action today to mitigate them. The first steps to ensure that finance is aligned with the low-carbon transition are to quantify the climate risks that the industry will realise in the future and to shift them into the present. For that, we need to turn to public policy.

Transition risks can be realized today, reducing the incentive to fund carbon-intensive companies. They include everything from a possible future carbon price, restrictions on carbon-intensive activities, the emergence of disruptive technologies, and an increase in litigation. States committed to honouring COP21 will increasingly impose policies that penalise activities that damage the environment and promote activities that benefit it.

A key issue that both investors and regulators face is a lack of data and metrics to identify the precise exposure of companies to climate risks and their impact on the environment. Without them, investors cannot make decisions to rebalance their portfolios, and regulators cannot design optimal policies. Irene Monasterolo, assistant professor at WU’s Institute for Ecological Economics, says having timely, consistent and credible climate policies would minimise market uncertainty and risks to financial stability.

Awareness of climate risk is also generating demand for portfolio stress-testing, with UniCredit SpA, Allianz and the Industrial and Commercial Bank of China all producing scenario analyses. New and innovative approaches to stress-testing include ‘Bayesian network modelling’ – led by Riccardo Rebonato, Professor of Finance at EDHEC Business School – which offers a logically consistent yet intuitive way to deal with uncertain events.

While better risk assessment tools are essential, they are not enough. We also need a bigger pool of viable green projects so investors can fund the low-carbon transition. Here, public policy plays an essential role, too.

The green bonds fund renewable energy, low-carbon transport, energy-efficient buildings and sustainable water; projects that involve the installation of proven technologies with high up-front costs, but long, stable cash flows. They are a natural fit for pension funds and insurers, which have long-term liabilities.

Long-term infrastructure projects such as these are typically very sensitive to the cost of financing. Policies that bring down these costs would significantly increase the attractiveness of starting low-carbon projects. While there is more to green finance than green bonds, scaling the green bond market offers the shortest route to growth in the overall sector.

One option is to increase public bond issuance. The European Investment Bank and the China Development Bank are big issuers of green bonds, as are the state of California and the Republic of France. Funds raised by public issuers at low rates can be used to fund public works, provide subsided finance to green companies or fund credit enhancements for pools of riskier projects. All three uses would attract additional private capital. Sovereign issuance should be rapidly scaled up.

Governments could also work with public-sector pension funds to direct their capital into the green bond market, pushing down the cost of capital. Requiring that public funds own sovereign and corporate green bonds would resemble features of the world’s first bond market, in 13th century Venice. Prestiti were mandatory long-term loans from citizens to the Venetian state to fund wars against the Byzantine Empire. In 1261 under the Ligato Pecuniae, Venice placed all its debts into a permanent fund paying 5% interest and allowed citizens to trade it on secondary markets. The move not only democratised finance, by broadening the creditor base, but aligned it with the goals of the state.

Modern central banks with revised mandates could play a vital role along similar lines in the development of the green bond market. Their ability to buy and hold sovereign and commercial bonds can affect the level of investment in the economy.

However, if central bankers’ policies are to have maximum effect, we need to learn from the post-crisis experience. Philippa Sigl-Glöckner, who works on visualising financial systems at Imperial College London, has created a striking graphic that shows the extent to which the ECB’s money injections have remained within the euro area’s financial system. According to the Deutsche Bundesbank, external financing into the euro area’s real economy since 2015 has been flat, despite €2.3 trillion in asset purchases (QE) by the ECB. The link between QE and real investment appears to be rather tenuous.

To be a success, green QE should be coupled with new issuances of green bonds by governments and development banks that have earmarked specific green investments. States that control their currency can issue as much debt funded by either central banks or the private sector as is consistent with their output gaps, low inflation and appropriate models of risk. Not all new public debt, of course, can be earmarked for green investment, and not all QE should be green. But given the financial stability risks posed by high-carbon investments, there is a good case for a sizeable portion of central banks’ asset purchases to be in green bonds.

As an arm of the state, the central bank is immune from the “myopic loss aversion” that economists say guides investing behaviour, pushing up financing costs. It can therefore be an additional source of low-cost, long-term patient capital, while building liquidity and private sector confidence in the green bond market.

Regulators can also use macroprudential policies to discourage bank lending into unsustainable industries by raising the capital requirements of banks that excessively do so. Financial instability, however, goes in all directions, and it is important that central bankers avoid giving excessive support to the green economy, fostering a damaging bubble in the sector.

Time for action

While we are currently falling behind in our efforts to beat climate change, it is still within our power to avoid the worst. A financial services industry that knows and bears the risks of inaction and has plentiful projects into which to redirect its capital will take up the challenge. Policymakers need to play their role too, creating the conditions under which the green transition can happen.